House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon. P.J. Keating, M.P.)

MAIN FEATURES

The main features of the principal Bill - the Taxation Laws Amendment Bill (No. 5) 1986 - are as follows:

Instalments of provisional tax (Clauses 4, 14 to 30, 32 and 35)

The Bill will give effect to the proposal, announced in the 19 September 1985 Statement on Reform of the Australian Taxation System, to introduce a system for the payment of provisional tax by instalments, commencing in 1987-88.

Subject to certain exceptions (see below), the system will require all provisional taxpayers to pay four instalments of provisional tax each year, the instalments being due no earlier than 1 September, 1 December, 1 March and 1 June respectively. The first three instalments will ordinarily be one-quarter of the taxpayer's provisional tax for the previous year. If, however, the taxpayer makes an application to vary provisional tax in accordance with the taxpayer's estimate of taxable income, all instalments for the rest of that year, including the fourth, will be based on the varied provisional tax. If, for example, the taxpayer's estimate is made in relation to the third instalment, the third instalment will be three-quarters of the varied provisional tax amount less the sum of the amounts charged as the first and second instalments. Taxpayers will be entitled to make a fresh self-assessment of provisional tax in this way in relation to each of the four instalments, subject to penalty for underestimations (see below). Special rules will apply where the estimate is made in relation to a first instalment (see below).

Where the taxpayer does not make an estimate of provisional tax, the fourth instalment will be the amount, if any, required to make the sum of the four instalments equal to the amount of provisional tax calculated according to the existing law (the "basic provisional tax amount"). The fourth instalment notice in such a case will not, therefore, issue before the taxpayer's income tax assessment notice for the previous year issues. If that assessment notice issues on or before the date of issue of an earlier instalment notice, the basic provisional tax amount will be used in calculating that instalment only where the basic provisional tax amount is less than the previous year's provisional tax (assuming the taxpayer has not made an estimate of the current year's provisional tax).

The exceptions to the general rules just outlined are -

•

the instalment system will not apply in a particular year until the previous year's provisional tax has been ascertained - that is, until the taxpayer's income tax assessment notice for the year before that has issued;

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the instalment system will not apply where the taxpayer's previous year's provisional tax, as at the date on which the first instalment notice would issue, does not exceed $2000;

•

the instalment system will not apply in respect of the income of a year of income if the taxpayer's income tax assessment notice for the previous year issues before the first instalment notice would issue;

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in 1987-88 the first instalment will not be due and payable before 1 December 1987, but that instalment will be an amount equal to one-half of the previous year's provisional tax (subject, in the usual way, to self-assessment by the taxpayer); and

•

taxpayers who satisfy the Commissioner of Taxation that they will derive more than three-quarters of their assessable income after 1 December will pay two instalments of provisional tax - an amount equal to one-half of the previous year's provisional tax no earlier than 1 February and the balance of the basic provisional tax amount no earlier than 1 June.

If, at any time during the year, the sum of the instalments paid by the taxpayer to that time exceeds the basic provisional tax amount (or varied provisional tax, where relevant), the excess will be refunded or applied in payment of any outstanding income tax. Upon assessment, instalments of provisional tax will be credited, as is provisional tax under the existing law, in payment of tax assessed.

Where a taxpayer applies to have the first instalment recalculated on the basis of the taxpayer's estimate of taxable income, that estimate will generally be effective only for the first instalment. If the taxpayer wants to have that estimate given effect to in further instalment calculations, a further application will have to be lodged with the Commissioner of Taxation. That will not be the case, however, where the varied provisional tax arising from the first estimate is calculated according to the legislation imposing tax and setting other rules for the assessment of tax for the year of income, or where, having used the previous year's rates and rules in calculating that varied provisional tax, either the varied provisional tax is NIL or the relevant law does not change between the dates on which the first and second instalment notices issue. Varied provisional tax will not be calculated in respect of a second or later instalment estimate until the legislation imposing tax and making any changes to assessment rules for the current year has received the Royal Assent.

Where a taxpayer's instalment is based on an underestimate of taxable income of more than 10% in an application to have provisional tax varied, additional tax will be payable at the rate of 20% per annum on the shortfall from the due date for payment of that instalment to the due date of the next. In the case of a final instalment, the penalty period will finish on the date on which tax is due and payable on assessment. The instalment shortfall in each case will be the difference between the instalment and the lesser of what the instalment would have been if it had been calculated by reference to the tax payable on assessment and what the instalment would have been if no estimate had been made.

Foreign currency exchange gains and losses (Clauses 9 and 13))

This Bill will implement the proposal, announced on 18 February 1986, to treat foreign exchange gains as assessable income or to allow an income tax deduction for foreign exchange losses (i.e., gains and losses due to foreign exchange rate fluctuations) of a capital nature realised on or after 19 February 1986.

It is established law that foreign exchange gains and losses are assessable income or allowable as deductions where the gain or loss is of a revenue nature, e.g., where the gain or loss arises from the receipt or payment of an amount on the sale or purchase of trading stock or on the repayment of borrowings to purchase trading stock. Gains or losses on interest receipts are also revenue items. A gain or loss is of a capital nature where it arises from the receipt or payment of an amount such as the proceeds from the sale of a business or from repayment of principal on borrowings to expand a business.

In the case of a financial institution, foreign exchange gains and losses on the repayment of borrowings for use in the ordinary course of business in lending to customers are of a revenue nature. Borrowings made to strengthen the capital structure are of a capital nature.

"Gains and losses" realised from forward cover or other currency hedging contracts derive their character as an income or capital transaction from the nature of the underlying transactions which necessitated the hedge or forward cover. Exchange gains and losses realised by financial institutions from participation in hedging contracts with other businesses are generally on revenue account.

The measures proposed in the Bill are to apply to foreign exchange gains made and losses incurred on contracts for borrowings to the extent to which the money borrowed is used for the purpose of producing assessable income or in carrying on a business for that purpose. A foreign exchange gain made or loss incurred on a loan made by a taxpayer is also to fall within the new provisions where the loan was made for the purpose of producing assessable income and the foreign exchange gain or loss on the loan would not be assessable income or an allowable deduction under the existing law (as it would be where the lender is in the business of lending money).

The proposed measures are also to apply to foreign exchange gains and losses made on certain contracts entered into on or after 19 February 1986 for the purchase or sale of an asset, the price of which is specified in foreign currency. Under the proposed provisions, any gain made or loss incurred due to foreign exchange rate fluctuations between the time of purchase of a capital asset (e.g., a building) and the later time of payment of the purchase price will be assessable income or an allowable deduction where, if the taxpayer had borrowed money and paid for the asset at the time of purchase, interest on that borrowing would have been an allowable deduction to the taxpayer. Corresponding rules apply to a gain made or loss incurred, due to such fluctuations, on the sale of a capital asset.

Gains or losses made on forward cover contracts (or on foreign currency received under such contracts) and other hedge contracts entered into by a taxpayer to eliminate or reduce the risk of a loss to the taxpayer or an associate from foreign exchange rate fluctuations on a contract of the type outlined above are also to be assessable income of, or an allowable income tax deduction to, the taxpayer.

An exchange gain will not be assessable, nor an exchange loss deductible, until the gain or loss is realised. In broad terms, in the case of a borrowing or loan, this will be when the borrowing or loan (or an instalment) is repaid and, in the case of a contract for the sale or purchase of an asset, when the taxpayer receives or makes the payment for the asset (or an instalment of the payment).

The Bill requires a draw down that is made at the option of the borrower, on or after 19 February 1986, under a draw down facility in a contract entered into before that date, to be treated, in effect, as a borrowing of the amount drawn down contracted at the time when the money was received. These measures will apply whether the taxpayer is the lender or borrower of the monies drawn down.

With certain exceptions, a rollover (in whole or part) or extension, on or after 19 February 1986, of a borrowing contracted for before that date will be taken as a borrowing or loan made by the taxpayer at the time of the rollover or at the commencement of the extension period. An exception is where the taxpayer was contractually bound, before 19 February 1986, to make the rollover or to extend the period of the borrowing or loan.

Where the new provisions apply to deem a borrowing or loan that is rolled over or extended to be a new borrowing or loan, that new borrowing or loan will be taken into account at the value, at the time of the rollover, of the currency that is rolled over or in the case of an extension of a borrowing or loan, as the amount outstanding under the contract immediately before the commencement of the extension period.

Whether the whole or a part of a loan had been rolled-over, and so falls within the scope of this legislation, will ordinarily be clear from the facts of the particular case. The exercise, on or after 19 February 1986, of an option to renew a loan in whole or in part would give rise to a new loan. On the other hand, the mere regular adjustment during the term of a loan of the loan interest rate would not result in the loan being taken as a new loan. For example, the use of an interest rate re-setting facility such as revolving note issues, some of which occur on or after 19 February 1986, to set a market interest rate on a loan would not make the loan a new loan where the relevant borrowing was contracted for before 19 February 1986, was for a specified amount and a fixed term, and the borrower was, before 19 February 1986, committed to that facility by the underlying loan contract or a related contract (e.g., a currency swap contract).

Where rights or obligations under a contract entered into before 19 February 1986 are assigned to (or taken over by) a taxpayer on or after that date the contract, in the hands of that taxpayer will be a new contract except where necessary to prevent tax avoidance.

As a foreign exchange loss on a borrowing is, in effect, an increase in interest payable on the borrowing, such a loss on a borrowing to finance a rental property investment is to be treated as rental property loan interest for the purposes of the provisions of Subdivision G of Division 3 of Part III of the Income Tax Assessment Act 1936 which imposes a limit on the aggregate annual deduction for interest on money borrowed to finance rental property investments made after 17 July 1985.

In the reverse situation, that is where a foreign exchange gain is made on such borrowings, that gain is to be treated for the purposes of those provisions as rental property income against which any rental property loan interest may be offset.

The Bill contains several tax avoidance measures. A deduction is to be denied for foreign exchange losses covered by a hedging contract or similar arrangement, where the hedging contract produces a gain which is not assessable income of the Australian resident taxpayer. It will apply whether the arrangement is entered into directly by that taxpayer, through an associate or by an arm's length party under a reimbursement arrangement.

A deduction will not be available for a foreign exchange loss unless the taxpayer has notified the Commissioner in writing that the contract has been entered into (and of the terms of the contract) no later than the date of lodgment of the taxpayer's first income tax return after the contract was entered into or, if later, the date of lodgment of the taxpayer's first income tax return after the commencement of these provisions. The Commissioner may extend the date by which a taxpayer must notify him of these matters.

Exemption of certain gains and losses (Clauses 12 and 32)

The Bill proposes a complementary amendment to section 160ZB of the Income Tax Assessment Act 1936 so that the provisions of that Act relating to capital gains and capital losses will not apply to a capital gain made, or a capital loss incurred, under a hedging contract (including a gain or loss on currency received under such a contract) that was entered into for the sole purpose of eliminating or reducing the risk of losses that might result from currency rate fluctuations in relation to another contract, where any actual gains or losses from such fluctuations on that other contract would not fall within the provisions relating to capital gains and losses.

Short-term share-based financing arrangements (Clauses 7, 8, 10, 11 and 31)

This Bill will implement the proposal, announced on 7 April 1986, to treat as debt for income tax purposes shorter-term redeemable preference shares. Reflecting the mischief described in the announcement, these measures are not confined to redeemable shares strictly so-called, but will apply to any shares used as part of a financing arrangement for an effective term to maturity of 2 years or less. Dividends paid on such shares will not be eligible for the intercorporate dividend rebate, but will be deductible to the company that issued the shares.

Under the income tax law, a company obtaining debt finance and paying interest can deduct that interest and the company receiving it is taxed on it. Dividends are not deductible to the paying company, but the rebate allowable under section 46 of the Income Tax Assessment Act 1936 (the 'Assessment Act') makes them tax free in the hands of the company receiving them. Where both companies are fully taxable, neither gains from the use of short-term shares in lieu of debt and the outcome is tax neutral. However, the different tax treatment of dividends makes short-term share-based financing arrangements attractive to tax loss and tax exempt companies that have no taxable income and are thus unable to benefit from interest deductions allowed on finance obtained by conventional borrowings. By allowing what amounts to 'debt' to receive the tax treatment of equity, these arrangements allow companies in the situations described above to obtain a cash flow advantage which is reflected in a corresponding loss to the revenue by a reduction in tax paid by the lending company.

The amendments contained in this Bill are designed to remove these tax advantages by effectively treating short-term share-based financing arrangements as debt transactions. Accordingly, a rebate of tax under section 46 - or, to a lesser extent where dividend stripping is involved, under section 46A - of the Assessment Act will be denied to a lending company on dividends received under arrangements involving the use of shares where it may be reasonably concluded that the arrangements were entered into for the purpose of enabling a company to obtain finance for a period not exceeding 2 years and that the payment of dividends is equivalent to the payment of interest.

Consistent with the principle of treating the relevant transactions as debt finance, where the proposed amendments operate to deny a rebate of tax on dividends received by a lender, the company paying the dividends is to be allowed a deduction in respect of those dividends to the same extent as the amount would have qualified as a deduction had the payment of the dividend been interest incurred on a loan.

The new measures will apply on the basis outlined above where any of the entities concerned are corporate unit trusts or public trading trusts the trustees of which, in accordance with Divisions 6B and 6C respectively of the Assessment Act, are treated as companies for income tax purposes.

They will also operate to deny a rebate of tax on dividends received by Australian resident companies from non-resident companies under similar short-term share-based financing arrangements. This will remove the tax benefit sought to be obtained under such arrangements where shares were used for investment in offshore companies to convert what otherwise would be income subject to tax in Australia, into tax-free dividends here.

The proposed measures apply to dividends paid on affected shares issued after 5.00pm AEST on 7 April 1986. Safeguarding provisions will ensure that these measures also apply to dividends paid on shares issued before, but used (whether by an extension of an earlier arrangement or otherwise) after that time as part of a short-term financing arrangement.

To avoid any element of retrospectivity, the measures contained in this Bill will not apply to short-term financing arrangements entered into before 5.00pm AEST on 7 April 1986 and under which, pursuant to provisions in the articles of association of a company, an obligation to pay dividends on redeemable shares is to be met by the issue of further such shares in the company after that time.

Exemptions (Clauses 6 and 32)

The Bill will exempt from tax the income of The British Phosphate Commissioners Banaba Contingency Fund (the Fund) which was established on 1 June 1981 to meet any future claims for compensation by former employees of the British Phosphate Commissioners in respect of phosphate mining operations on Banaba (formerly Ocean Island). Mining operations ceased on Banaba in 1980 and the affairs of the Commissioners are in the process of being wound up.

The income of the Commissioners, as representatives of the Governments of Australia, the United Kingdom and New Zealand, is exempt from tax under the doctrine of sovereign immunity and had the Commissioners been in a position to continue to administer the Fund any income derived by it would have remained exempt.

A more detailed explanation of the provisions of the Bills is contained in the following notes.